Good-bye cathartic October

2 November 2018

What a difference one month can make. At the end of September, one of the biggest conundrums of 2018 was the divergence of stock market returns between the US (strongly positive) and the rest of the world (flat). October’s stock market correction brought falls of similar magnitude to all markets, but clearly originated in the US, before contagion spread around the world. Initially, it was caused by concerns that rising US bond yields would diminish stock returns, as higher costs of finance eat into corporate profit margins and geared share investments on the back of cheap credit becoming less attractive.

As we wrote over the course of the month, a classic credit crunch in China exacerbated the liquidity squeeze that stock market sell-offs inevitably cause and made it much harder than usual to apply past experience to predict the turning points of this correction. The continued stream of strong corporate earnings announcements and an absence of signs of a looming recession made the stock market downdraft even more eerie.

And once sentiment turns negative, all other issues with scare potential are pulled ‘˜out of the cupboard’, even though they had been in clear sight all along, especially during the September rally. Globally, the main cited scare is the prospect of a trade war between the two largest single economies on the planet – China and the US. In Europe it was Italy’s defiance to Brussels’ austerity dictate and of course the Brexit no-deal evergreen.

So, while there may have been good reason at the beginning of the sell-off for stock markets – particularly in the US – to adjust downwards (given the higher yield and interest rate environment), once the -10% correction level was reached at the end of the month there was a widespread consensus amongst investment professionals that markets had overshot on the downside. Just like at the end of the last meaningful correction in the first quarter of 2016, stock market valuations are now suggesting that we should brace ourselves for an economic downturn. Different to then however, there is even less evidence from the actual economy that this will happen.

Somewhat predictably therefore, the week started with a decent recovery rally, allowing October to close on a positive note and not on the previous week’s lows. The recovery has already stalled on the second day of November, despite (or more likely because of) good economic reports from the US. Job growths has picked up further than one might have thought possible with an unemployment rate of just 3.7% and that had November start in precisely the same way as October – long term yields rising back to where they had jumped to (but since slightly declined from) at the beginning of last month.

From a technical perspective, this stalling also made some sense, because markets had never reached the so called ‘˜capitulation stage’ and had also moved up so quickly that various technical indicators had switched back to sell. We are also not convinced this correction has yet run its course, but we do know that the fall in valuation levels relative to the economic outlook has created a much better entry point than we had at the end of September. We are therefore not unhappy to have executed our portfolio update and rebalance over the course of last week.

Much now hinges on the outcome of next week’s US Midterm election, when the US elects all members of the House of Representatives (the lower house of the US parliament) and a third of the Senate (the upper house). At the moment, markets seem to have priced in that Donald Trump’s Republican party will narrowly lose the House of Representatives (as most presidents before him) but not the Senate. Any material deviation from these expectations would likely trigger further market volatility. Should Trump unexpectedly retain the lower house, then markets may well rally in the short-term on the expectation of further tax cuts – this time for middle income households rather than businesses and the wealthy.

Should he lose more decisively than expected, then vice versa. In that case, another fall in the short term may be on the cards, although it could over the medium-term also mean that the risks of an ever-increasing US fiscal deficit and the trade war with China may be more containable (through stricter oversight by the legislature).

While much focus of capital markets understandably rested on the US, the media in the UK was clearly more occupied with reporting about the autumn budget, the latest Brexit developments, the Bank of England’s rate setting committee meeting and the announcement from Germany’s head of government Angela Merkel that she will not seek a 5th (!) term in 2021.

The UK budget and the latest Brexit developments seem quite interconnected, because the EU seemed to be proposing an economically attractive compromise for the immediate post-Brexit trade framework which the Tory Brexiteer fraction would struggle to accept, given Northern Ireland would enjoy a slightly different customs status than the rest of the UK. But it seems that, to persuade them to behave more pragmatically then they would like to, the chancellor presented a budget with tax cuts and NHS spending boosters that would come into force after Brexit in the next fiscal year. The catch is that it’s entirely conditional on a continuation of the recent supportive economic environment, which itself depends on a soft Brexit, preferably with a customs union that keeps trade disruption to a minimum.

Mark Carney’s Bank of England monetary policy announcement seemed similarly Brexit conditional, even though he would not let himself be tied down to a statement whether a disorderly exit from the EU was more likely to lead to rate cuts or rate hikes. However, it was fairly clear that, if the economy continues on its current course of slow but steady expansion, then the next rate rise is likely to be next May (to 1%) – and there would be more to follow.

Lastly, we come to the beginning of the end of the Merkel-era and speculation on whether this will be good or bad news for the Brexit negotiations or lead to a general weakening of the remaining EU. From my personal vantage point, I would be very surprised to see significant changes in Germany’s foreign and European policies. This is not to say that Merkel is likely to cling to power until 2021. Rather, recent history has shown that Germany’s European commitment is firmly anchored across a very wide section of German society and has not much changed when political leadership passed from one of the main parties to the other.

In terms of market action between now and the end of the year, it is very hard to predict whether optimism or pessimism will prevail. However, over the medium-term, it is economic circumstances and corporate results that determine the stock markets’ direction. And from that angle, regardless how unpleasant the market volatility in October has behave market valuations become too pessimistic?